Wednesday, June 27, 2018

Czech raises rate 25 bps as inflation exceeds forecast

The central bank of the Czech Republic raised its benchmark 2-week repurchase rate for the fourth time since embarking on a monetary tightening cycle as higher than expected inflation at home and abroad along with a weaker koruna made it necessary to raise rates earlier than forecast.

The Czech National Bank (CNB) raised its policy rate by another 25 basis points to 1.0 percent and has now raised it by 95 basis points since August 2017 when it began raising rates in response to accelerating inflation from a booming economy and rising wages.

It is CNB's second rate hike this year following an increase in February and was largely expected after CNB Governor Jiri Rusnok's earlier this month said the combination of a weaker than expected koruna and higher than expected wage rises had made room for an earlier rate rise.

At its previous policy meeting in May, when the CNB left its rates steady, Rusnok said a rate hike toward the end of the year was being considered. However, he also said an earlier hike could not be ruled out if the situation differed significantly from assumptions.

Since May two things have changed. First, oil prices have risen more than than expected and the consensus now looks for prices in 2018 to average $73.2 a barrel, up from CNB's forecast of $66.9.

Secondly, the U.S. dollar has risen on a combination of strong U.S. economic growth, a more hawkish Federal Reserve and a more dovish European Central Bank (ECB).

"These two factors are thus jointly fostering a higher koruna price of oil," Rusnok said, adding a desired tightening of monetary conditions through a higher exchange rate was not taking place and this trend may persist.

"It is therefore necessary and appropriate to increase interest rates earlier than implied by the current forecast presented in early May," he said.

In May the CNB forecast inflation of 1.9 percent in May but it turned out to be 2.2 percent, above the bank's 2.0 percent target due to higher prices of food and non-alcoholic beverages, and transport costs, including fuel.

Wages rose 8.6 percent in the first quarter, above the forecast 8.5 percent, as a shortage of available labour results in a overheated jobs market.

"At its meeting today, however, the Bank Board assessed the risks to the current forecast as being inflationary," Rusnok said.

In May the CNB forecast a 2018 euro-dollar rate of 1.23 but consensus is now looking to 1.20. For 2019 the euro-dollar rate has fallen to 1.22 from May's 1.24 forecast.

In response to today's hike, the koruna rose, reversing a steady decline since mid-April, but then quickly gave up its gains to end largely unchanged.

The koruna was trading at 25.9 and is 0.8 percent below its level at the start of 2018.

But the koruna is still significantly higher than during nearly five years of extraordinary easy policy when the CNB used interventions in currency markets to keep the koruna below 27 to the euro to avoid deflationary pressures.

In May the CNB forecast an average exchange rate of the koruna to the euro of 25 and in 2019 a rate of 24.4.

In an unanimous decision, the CNB board also raised its Lombard rate, which is used by banks to obtain overnight liquidity and sets a ceiling for short-term rates, by 50 basis points to 2.0 percent. However, it maintained the discount rate, which sets a floor for short-term money market rates, at 0.05 percent.

While inflation has risen faster than expected, the Czech economy has slowed more than expected due to a stronger negative contribution of net exports, lower inventory build-up and household consumption.

Annual growth in the first quarter was 4.4 percent, below 4.9 percent forecast, and down from 5.5 percent in the fourth quarter of last year. In May the CNB forecast that growth this year of 3.9 percent and the slow further to 3.4 percent in 2019.

Earlier this week the International Monetary Fund (IMF) commended the Czech Republic for its strong economy and favorable outlook though it also said the decline in the labour force poses a longer term challenge and in the near term a decline in global trade from increased protectionism poses a major risk given how tightly integrated the Czech economy is in global supply chains.

The IMF forecast growth this year of 3.7 percent, down from 2017's 4.4 percent, and then growth of 3.2 percent in 2019 and 2.5 percent in 2020 as domestic demand slowly cools from 4.0 percent growth this year to 3.7 percent and 3.1 percent in the next two years.

Inflation is forecast to average 2.3 percent this year, slightly down from 2.4 percent last year, and then 2.3 percent in 2019 and 2.0 percent in 2020.

The Czech National Bank issued the following statement:

"At its meeting today, the Bank Board of the Czech National Bank unanimously increased the two-week repo rate by 25 basis points to 1%. At the same time, it increased the Lombard rate by 50 basis points to 2% and kept the discount rate unchanged at 0.05%.

The May forecast expected inflation to be slightly below the 2% target this year and return very close to it during next year. Consistent with the current forecast was broad stability of market interest rates initially, followed by further growth in rates from late 2018/early 2019. At its meeting today, however, the Bank Board assessed the risks to the current forecast as being inflationary.

The outlook for foreign producer price inflation is higher compared to the assumptions of the forecast. This is particularly true for this year, owing to an increase in oil prices. The expected evolution of consumer prices, economic growth and euro interest rates is essentially unchanged in terms of annual averages. The market outlook for the Brent crude oil price is higher than the forecast. The expected dollar-euro exchange rate has shifted towards a weaker euro. These two factors are thus jointly fostering a higher koruna price of oil.

Domestic inflation has gradually increased so far in Q2 and slightly exceeded the Czech National Bank’s 2% target in May. The higher-than-forecasted inflation in May was due mainly to faster growth in prices of fuels and food. Slightly higher core inflation also contributed to a lesser extent. Growth in administered prices and the first-round effects of changes to indirect taxes were in line with the forecast.

As forecasted, the growth of the Czech economy slowed in Q1. However, the slowdown was rather more pronounced than the central bank had expected. This was due mainly to a stronger negative contribution of net exports and lower additions to inventories. Household consumption also recorded slightly slower growth. Nevertheless, it remained robust due to a strong labour market and ensuing rapid growth in household income. By contrast, the contributions of fixed investment and government consumption to economic growth were stronger than forecasted.

According to the monthly indicators, industrial and construction output and retail sales are slowing further. This suggests – in line with the Czech National Bank’s current forecast – a further slowdown in annual economic growth in 2018 Q2.

Labour market indicators point to continued overheating of the labour market. Employment continued to rise apace and exceeded the forecast amid strong labour demand. In line with expectations, unemployment declined slightly. The high labour demand coupled with a shortage of available labour led to a further marked increase in job vacancies. As expected, wage growth accelerated further in Q1. Although it fell short of the prediction in market sectors, it exceeded the forecast in non-market sectors.

To sum up the important facts about recent developments in the Czech economy, GDP growth in Q1 was below the forecast. By contrast, inflation in May was higher than forecasted. The evolution of unemployment and wages was broadly in line with the Czech National Bank’s forecast.

The Bank Board assessed the risks to the current inflation forecast at the monetary policy horizon as being inflationary and speaking in favour of an earlier interest rate increase. The recent exchange rate developments mean that a desirable tightening of the exchange rate component of the monetary conditions is not taking place, and this trend may persist. It is therefore necessary and appropriate to increase interest rates earlier than implied by the current forecast presented in early May. Higher-than-forecasted domestic inflation and stronger-than-forecasted inflationary pressures from abroad, linked mainly with oil prices, also speak in favour of an interest rate increase."